Cryptocurrencies and the technology that enables them, blockchain, are here and they are here to stay.
They are not a fad. If there are circles, and there are many circles for that matter who still view them as a passing fad, then they are a fad that has been around for just over 14 years.
The first of the legions of cryptocurrencies, Bitcoin was invented in 2008 by a little known individual Satoshi Nakamoto. Protagonists of cryptocurrencies have touted the 14-year-old invention as humanity’s giant leap forward in financial innovation. Cryptocurrency’s longevity so far and its now widespread innovation, however, should not be taken as a ringing endorsement.
A loose definition of cryptocurrency is that it is a virtual currency designed to revolutionize peer to peer transactions without the need for an intermediary like a bank or a credit card agency, the exchange of personal information and or transaction fees.
Central to bitcoin and any other cryptocurrency for that matter is blockchain technology which it uses to record transactions on its network.
A blockchain is essentially a publicly distributed ledger that records each transaction ever made on the block. When that block memory is full it is added in sequential order to the chain of blocks. This ledger is freely available on any computer on the bitcoin network, and it validates bitcoin transactions, stores them on the blockchain and relays the transactions to the network of computers. The computers on the network are called nodes.
Because the blockchain database is said to be stored on a network of computers rather than on a server hacking or stealing bitcoin is said to be virtually impossible for would-be cybercriminals. A hacker would have to break into most nodes simultaneously which is highly improbable. There is also said to be a predetermined number of bitcoins that can ever be created meaning that the cryptocurrency cannot be devalued in the future by any central bank issuing more units of the cryptocurrency but this also by implication means that cryptocurrency is not regulated.
The most prominent of cryptocurrencies, Bitcoin makes a compelling case for investment. Since its “initial coin offering” or ICO in 2008 at 0.0008 per coin, it now trades at US$ 41,891.40 as of 21st April 2022. This is captured beautifully in the cryptocurrency’s price chart
Bitcoin has over the last 5 years seen its price surge to all time high levels starting in 2017 when it breached the US$20,000.00 mark before retreating to US$9,000.00 and then subsequently to US$3,500.00 in the year that followed of 2018. It has since breached the December 2017 price level and has gone on to set new record highs. If an individual had bought bitcoin when they were first issued in 2008 and held them to date, they would have made a massive fortune depending on how much they would have invested. If the same individual had the opportunity to buy Bitcoin when it was first issued in 2008 at US$0.0008 and they spent US$ 1,000.00 and held all of them to date without ever selling one. That individual would have no less than US$ 52,364,250,000 in Bitcoin!
A fortune of that magnitude would make that individual as wealthy as Michael Dell, the computer and technology billionaire from the US and Amancio Ortega Gaona, the Spanish clothing titan. Both men boast fortunes of US$ 55 billion and US$ 59 billion respectively.
A fortune of that magnitude would make that individual richer than Phil Knight, the founder of sports apparel behemoth Nike whose fortune according to Forbes stands at US$ 47.3 billion and richer than Mackenzie Scott whose money is in that region. Perhaps most astoundingly, a person who would have invested in Bitcoin from its inception in 2008 and held their coins to date would be twice as rich as Jack Ma and three times richer than Africa’s richest man Aliko Dangote!
With that kind of price performance its no surprise then that all and sundry have come salivating to the cryptocurrency fray. The novel financial innovation has all kind of supporters ranging from obscure and unsavory internet figures and influencers to mainstream businesspeople and individuals.
The foremost of these is billionaire tech titans Reid Hoffman and Peter Thiel. Both men have asserted that cryptocurrency has a critical role to play in the portfolios of investors in general. Thiel set the internet on fire in March after he called Warren Buffett “the sociopathic Grandpa from Omaha,” for his critical stance on Bitcoin especially and cryptocurrency in general.
Ricardo Salinas Pliego is another billionaire proponent of cryptocurrency. He recently made pronouncements to the effect that the bulk of his liquidity portfolio consists of cryptocurrencies.
Despite their exponential rise in price, Bitcoin and other cryptocurrencies are not favoured by some financial sector heavyweights like Warren Buffett, and John Paulson, the hedge fund manager who made billions for himself and his clients betting against the housing market during the subprime mortgage crisis in 2008. Jamie Dimon, the long serving chief executive of US banking giant J.P Morgan is another outspoken cryptocurrency critic. Christine Largade, the IMF chief said in an interview on Bloomberg that Bitcoin is not a currency but a highly volatile digital asset. Notwithstanding its critics one country in South America, El Salvador adopted Bitcoin as legal tender and official currency in its country. Tesla, the electronic car manufacturer at one point started accepting cryptocurrency in exchange for its products and services. The opinion is split on the merits and applications of cryptocurrencies in the future. Detractors of cryptocurrency cite its volatility as a deterrent to it being adopted as a currency or even being considered as an investment.
Other detractors still have raised issues around money laundering, the opacity of cryptocurrencies in general and the lack of general regulation as the biggest risk for any person considering adding this to their investment portfolio. Bitcoin has reportedly been used by criminals to launder money and it has also been used on the Silk Road to fund criminal activities. Recently the world has witnessed the conflict between Russia and Ukraine as well as the resulting sanctions against Russia. The sanctions against Russia have been so unprecedented that the country has been cut off from at least half of its foreign exchange reserves. In response to sanctions the country has considered the use of cryptocurrencies as a way of financing its war machine. Should Russia pursue this avenue, there would be no form of recourse or enforcing the specified sanctions as cryptocurrencies are often decentralized.
These reservations which are valid have not stopped leading financial services institutions from setting up desks to trade cryptocurrencies and platforms to enable their clients invest in and trade in cryptos. As mentioned earlier the participation of mainstream businesses and financial institutions in the cryptocurrency market should not be taken as a ringing endorsement of the innovation or an indication for investors to pile into the market. Financial institutions generally and historically have shown a propensity to pursue fees and profits sometimes to the expense and detriment of their clients. The most glaring case of this is the subprime mortgage crisis in the US which is one of the events that led to the creation of cryptocurrencies. Banks and related financial institutions were happy to lend to and participate in a market that as it turned out they knew could not sustain itself in the long run. They were happy to cream fees and profits from underwriting such loans. Why would their foray into cryptos be any different?
There are still risks inherent when it comes to cryptos. The biggest of the risks is its volatility. The proponents of cryptos are forecasting a price of US$ 1 million for Bitcoin. From this forecast, there is a lot of scope of growth and capital appreciation. Investors should find this prospect appealing however, it raises another critical concern. What is the price forecast of US$ 1 million based on?
This question raises a further question of what methods are used to value cryptocurrencies and Bitcoin in general? Cryptocurrencies do not create or generate any form of cash flow and therefore the orthodox methods of valuing security as propounded by general finance theory cannot apply in the valuation of cryptos. It would, therefore, appear to the common man that cryptos find their prices on the markets as the forces of supply and demand interact. There is no way that one can deduce whether the cryptos are under or overvalued at any price level. There is no way for instance, that an investor can interrogate the current price of say Bitcoin using traditional finance theory methods to examine whether the cryptocurrency is correctly priced.
The biggest risk posed by the emergence of the cryptocurrency market is systemic. This is the risk that affects the entire market or economy. It stems from the fact that cryptos by their nature are not regulated.
According to Time magazine the cryptocurrency market is now worth at least US$ 3 trillion. For some perspective, the cryptocurrency market is worth what the nation of China has in its foreign exchange reserves! If the forecasts being mooted by crypto protagonists are realized, then this figure could increase by up to 20 times! Again, for some perspective, this figure would be more than twice the size of the United States economy! This market is primed for regulation. In fact, regulation of the market is long overdue. There is no other market for investments of this size that does not have any kind of regulation.
Central banks of the leading countries of the world have mulled the idea of introducing digital currencies powered by blockchain technology in response to the popularity and adoption of cryptocurrencies. The sheer size of the market poses a substantial market risk to the global economy should an adverse development occur in the crypto space.
Cryptocurrencies for example are priced in United States dollars. This makes them linked one to the other in a symbiotic way such that if a negative development arises in the other it could adversely affect the other resulting in a contagion effect which would result in systemic crisis and failure. An example of this could be a scenario where investors use US dollar leverage or leverage in any other currency for that matter to take positions in the crypto market. It is well documented that cryptocurrencies are by their nature volatile.
If its participants leverage their positions in the hope of enhancing the returns of their investments in cryptos only for the market to suddenly decline and be subdued for a prolonged period it could be disastrous for the rest of the economy including the sectors that are not linked to or have a relationship with the cryptocurrency market. Regulation of this space is not optional. It is overdue!
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